Capital Markets Insights

Crypto’s Crash: Compliance Lessons Learned for Traditional Finance

We have witnessed several compliance challenges in the crypto space in recent months. These incidents have highlighted the importance of proper regulatory oversight and the potential risks associated with unregulated investing. Traditional investors can learn valuable lessons from these compliance issues to avoid repeating similar mistakes.

FTX, a cryptocurrency derivatives exchange, collapsed in November 2022. The exchange experienced a sudden drop in trading volume, leading to liquidity issues and forcing the platform to shut down. This collapse left many investors with their funds tied up in the exchange, unable to withdraw or transfer assets. The situation worsened when FTX imposed withdrawal limits, making it difficult for investors to withdraw their funds.

The impact of the collapse of FTX was significant for those who had money tied up in the exchange. Many investors were left without access to their funds for extended periods, and some lost considerable sums.

The impact of a lack of regulation

In addition to losing access to accounts and funds, investors were left with few options to try and recover losses, given the limited regulatory oversight of crypto markets.

The fact that crypto is largely unregulated was a contributing factor to the problems experienced by FTX investors. In traditional investing, strict regulations are in place to protect investors and ensure the market's stability. For example, regulators can step in to prevent systemic risks or fraud. However, in the cryptocurrency market, limited regulations are in place for some countries, and exchanges are often self-regulated.

What does this mean for traditional investment approaches? First, it highlights the importance of regulation in protecting investors and ensuring market stability. For the Crypto market to grow and flourish, there is a need for greater regulation to prevent these kinds of incidents. Until then, crypto investors need to understand the significant risks they are exposed to.

Secondly, it underscores the importance of transparency and accountability in investing. In traditional investing, investment banks must disclose information about their operations and financial performance to investors. The fundamental nature of Cryptocurrency as a decentralized, secure, highly encrypted currency means there will always be a degree of opaqueness surrounding crypto investments. While this offers investors good potential returns, it makes it hard for them to make informed decisions.

What might this mean for compliance in traditional investing?

There are a few changes to compliance and regulations that we may see introduced in the traditional finance and crypto investing in the future, including:

  1. Stricter regulations: While a lack of regulation is far from the sole reason that investors lost in the FTX fiasco, it has shown that more than self-regulation is needed to protect investors. In traditional investing we may see regulators introduce more stringent rules to prevent systemic risks or fraud. This could include requiring investment firms to maintain higher levels of capital, conducting regular audits, and enforcing penalties for non-compliance.
  2. Improved transparency: Transparency is crucial for investors to make informed decisions. Investment firms may need to disclose more information about their operations and financial performance and any potential conflicts of interest. Doing so may help investors better understand the risks and make more informed investment decisions.
  3. More robust cybersecurity measures: As more transactions move online, there is an increased risk of cyber attacks. Investment firms may need to implement stronger cybersecurity measures to protect their clients' personal and financial information. This could include implementing multi-factor authentication, encryption, and regular security audits.
  4. Increased focus on ethical investing: There is growing demand from investors for ethical investing options. Investment firms should be more transparent about their investments and consider the environmental, social, and governance (ESG) factors when making investment decisions. This helps protect investors from reputational risks and potential lawsuits.
  5. More education for investors: Many investors may need to fully understand the risks involved in investing, so investment firms may need to provide more education to their clients. This could include offering workshops, webinars, and other educational resources to help investors make more informed decisions.

Impacts for private placements and alternative investments

In private placements or other alternative investments, several regulatory factors protect investors in a way that doesn’t exist in the crypto space.

  1. Regulatory oversight: Private placements and other alternative investments are subject to regulatory oversight and disclosure requirements from the SEC, FINRA, IIROC or other regulatory bodies. On the other hand, crypto investments are mainly unregulated, which can increase the risk of fraud or manipulation.
  2. Investor eligibility: Private placements and alternative investments are typically only available to accredited investors meeting specific financial or professional criteria. On the other hand, crypto investments are an option for anyone with internet access and a cryptocurrency wallet, which can increase the risk of unsophisticated investors getting involved in complex or high-risk investments.
  3. Valuation: Private placements and other alternative investments typically have a transparent methodology for determining their value, which is disclosed to investors. On the other hand, crypto investments can be highly volatile and may need a straightforward process for determining their value, which can increase the risk of inaccurate or misleading valuations.
  4. Liquidity: Private placements and other alternative investments are often illiquid and may have lock-up periods or restrictions on when investors can sell their investments. On the other hand, crypto investments can be highly liquid and traded 24/7 on cryptocurrency exchanges, increasing the risk of market volatility and manipulation.

In conclusion, the recent compliance issues in the cryptocurrency industry serve as a cautionary tale for traditional finance markets. As investors increasingly seek alternative investments, investment firms and other entities must prioritize compliance and risk management to protect investors and maintain market stability.

Moving forward, investment firms and regulatory bodies must adapt to the evolving landscape of alternative investments, including cryptocurrencies, to ensure that they are adequately regulated and that investors are properly informed and protected. By leveraging technology and implementing robust compliance policies and procedures, investment firms and regulatory bodies can work together to mitigate the risks and promote the responsible growth of alternative investments, ultimately benefiting both investors and the broader financial system.